Federally regulated financial institutions, including banks, continue to play a pivotal role in commercial real estate financing. In the face of challenges within the commercial real estate sector, borrowers often find themselves in need of assistance from these lenders. However, regulated lenders frequently exhibit apprehension in taking actions that may attract regulatory scrutiny or prompt probing inquiries. This cautious approach often results in regulated lenders adopting a rigid stance, reminiscent of the Internal Revenue Service, with limited flexibility, creativity, cooperation, and speed. Consequently, workout negotiations may prove challenging or, in some instances, impossible, leading to the unfortunate default and foreclosure of loans that might have been salvaged with additional time and attention.
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Federal bank regulators recently issued a joint policy statement addressing commercial real estate loan accommodations and workouts to alter this dynamic. The efficacy of these efforts remains to be seen. Click here to view the statement.
The policy statement acknowledges "the importance of financial institutions working constructively with CRE borrowers experiencing financial difficulty." It references a policy statement from 2009 marked by similar challenges in the commercial real estate sector. While today's policy statement does not claim to revolutionize bank regulation, it does reassert the importance of lenders exercising flexibility and judgment when dealing with distressed borrowers. It restates two fundamental principles from the 2009 guidance:
Financial institutions implementing prudent CRE loan accommodation and workout arrangements, following a comprehensive review of a borrower's financial condition, will refrain from facing criticism for engaging in these efforts, even if they result in modified loans with weaknesses leading to adverse classification.
Modified loans to borrowers with the capacity to repay their debts according to reasonable terms will not be subject to adverse classification solely due to a decline in the value of the underlying collateral below the outstanding loan balance.
While these principles appear favorable, their application by regulated lenders remains contingent on their willingness to embrace them. The regulators' guidance also advocates for using short-term measures to assist borrowers during challenging periods rather than immediately declaring them in default. Short-term or temporary accommodations are deemed beneficial in mitigating long-term adverse effects on borrowers and are considered to be in the best interest of financial institutions.
Valuation considerations remain pivotal. Regulators emphasize the importance of lenders carefully evaluating the context-dependent value of collateral. The regulators encourage lenders to consider the "as stabilized" market value if collaboration with the borrower aims to achieve stabilized occupancy. Conversely, a lower "fair value" analysis is necessary in a foreclosure scenario. Determining "value" is acknowledged as a subjective judgment call rather than a fixed, immutable, scientific, or objectively determinable concept.
Regulators advocate for a comprehensive examination of temporary "financial difficulties" associated with a borrower's industry before classifying a loan as nonperforming.
The principles outlined by regulators provide federally regulated commercial real estate lenders with some latitude to defer decisions. While this strategy proved effective after the 2009 financial crisis, the current circumstances differ. Today's distress in the commercial real estate sector primarily arises from a substantial increase in interest rates driven by inflation, unlike the general panic in the financial system observed in 2009. With rates expected to remain elevated, borrowers, lenders, and regulators must collaboratively address the challenges posed by the need for refinancing in this new economic landscape. In the meantime, affording some breathing room may be helpful.